Total return hedge funds

What does the current interest rate environment mean for hedge funds?

The global economy is about to enter a new phase of the interest rate cycle. Aggressive rate rises are behind us and most major central banks are setting out plans for looser monetary policy.

As the outlook for interest rates becomes clearer, there is greater dispersion in the returns of individual asset classes. This, in turn, increases the number of relative value opportunities that investors can capitalise on.

In addition, while rates are set to decline, they are still likely to remain elevated – certainly compared with the era of zero to negative levels that followed the global financial crisis (GFC). This will lead to greater differentiation between companies and, therefore, more investment opportunities for fundamental stock pickers. In fact, historically, periods with high interest rates (above 4 per cent), have been characterised by strong returns and alpha generation by hedge funds.Goldman Sachs Prime Brokerage

With rates having peaked, companies will be more comfortable executing their longer-term strategy, leading to a gradual pick-up in public listings and mergers and acquisition (both of which have fallen sharply in recent years). Indeed, global M&A activity is forecast to increase by 50 per cent this year.Morgan Stanley Research This broadens the hunting field for hedge funds which can leverage such events to maximise returns.

For all these reasons, we believe that the prospects for alpha generation for fundamental investors are improving as markets become more sensitive to stock-specific factors rather than macro-economic shifts such as the path of interest rates.

While rates are still high, aren’t bonds still more attractive on a risk adjusted basis?

It’s true that, although rate cuts are coming, the reductions are unlikely to be aggressive or rushed. What is more, inflation could prove stickier than expected. Rates will therefore remain relatively high. You could argue that, while rates are high, it makes sense to invest in bonds, locking in the attractive yields still on offer with limited risk of those yields going up further (and thus of bond prices falling).

However, bonds aren’t the only instrument that benefits from elevated rates.

Higher short-term interest rates also support the absolute performance of long/short equity funds, particularly market neutral funds, whose short book is meaningful in order to achieve neutrality.

Why is that? When a hedge fund takes a short position, it borrows the security and provides cash collateral to the lender. During this borrowing period, the fund must pay the lender any dividends received on the stock, but it also earns interest on the cash collateral, known as the short rebate. Currently, short-term interest rates are at levels not seen since the GFC, resulting in significantly higher short rebates (see Fig. 1). The higher short rebate reduces the cost of carrying short positions which is now a structural tailwind for the absolute performance of these funds. In an environment which also favours alpha generation, this is effectively the cherry on the cake.

To simplify, a market neutral fund balances out long and short positions to achieve neutrality, which is broadly equivalent to holding its full value in cash (which earns the interest rate minus a spread) – only with the added benefit of possible additional and potentially significant returns from the underlying long and short positions (i.e. long/short performance spread or alpha).

The tailwind from the short rebate is just one of the reasons the coming months should be more favourable for relative hedge fund outperformance. As long as it doesn’t return to zero or negative, the rate environment will remain more supportive than it has been for the previous decade. Therefore market neutral strategies with a conservative risk return profile can complement a fixed income allocation, as they too mechanically benefit from higher rates.

In addition, the shape of the yield curve (both in the US and in Europe) means that hedge funds which see their large cash balances remunerated at the overnight interest rate are very well positioned relative to Treasury bonds from a yield perspective.

What benefits do hedge funds offer investors?

One of the key benefits is diversification.

Traditionally, investors used to hedge against the underperformance of equities by allocating a portion of their money to bonds. More recent history shows that this strategy alone may not achieve sufficient diversification because the correlation between bonds and equities changes over time. It is not consistently negative and is very much influenced by expected inflation (see Fig. 2).

Conversely, certain hedge fund strategies have a strong track record of performing independently of both equities and bonds.

The diversification benefits can be accessed in two main ways, depending on which type of hedge fund investors choose. Some serve as diversifiers because their returns show little or no correlation with those of equities and bonds. In this category we find multi-strategy and equity market neutral strategies.

Other strategies can serve as substitutes, capable of replacing a portion of equity investments in a portfolio and improving the risk return profile. Directional long/short equity funds fall in this category as they aim to offer returns similar to those of equity markets but with less volatility and limited drawdowns. Conservative equity market neutral funds or multi-strategy funds can also be used to improve the risk return profile of a bond allocation.

We are convinced that diversification will be a key consideration for investors in the years ahead, even more so than in the last 10 years (see our Secular outlook). Hedge funds, with their ability to decorrelate and protect the downside, will thus continue to play an important role in a global allocation.

How are your strategies capitalising on the opportunities?

Investing globally with no benchmark constraints allows investors to take advantage of the different stages of the business cycle across the globe through a mixture of long and short positions.

Today, for example, growth in Europe is subdued, and stock dispersion is high (underscored by the divergences of the recent earnings seasons). Such an environment tends to reward stock picking.

Asia is another region that offers a rich hunting ground for stock pickers.

For instance corporate governance reforms in Japan (including new rules on price/book ratios) are incentivising cash rich and unlevered companies to start or increase their dividend and buyback programmes. Shareholders are successfully lobbying companies to focus more on measures that can boost profitability, and we think that Japan is also uniquely placed to benefit from a boom of strategic activity via M&A, spin-offs, manager buyouts or joint ventures. Corporate reforms are incentivising companies to dispose of non-core subsidiaries, adding to an already favourable environment created by tax incentives, low interest rates and ample availability of private equity capital.

We also expect to see continued high levels of corporate activity in South East Asia and Australia. The former is benefiting from strong economic growth, capital flight away from China and an improving regulatory environment. The latter, meanwhile, is capitalising on its powerful position in the global commodity industry which is vital to the energy transition.

China is a market that investors have found challenging over the past three years, given deflationary pressures and property sector weakness. Yet, China still offers many bottom-up opportunities driven by changes in, for example, consumption habits and technology, and how well companies are adapting to these. We thus favour consumer companies that respond to more discerning and pragmatic consumers and have a tailwind from overseas growth, while we are cautious on industrial companies facing overcapacity and price pressures. We also remain positive on the semi and tech hardware sector in the region given the strong AI capex cycle in the coming years. Recently, several companies have moved to bolster shareholder returns by augmenting dividend payouts or implementing share buybacks. Following positive share price reactions, an increasing number of other businesses are now considering similar strategies.

Overall, we believe that changing market conditions mean that investors require a more agile approach to portfolio construction, and that the strategic case for hedge funds is as strong as it has ever been. As part of a diversified portfolio of stocks and bonds, hedge funds have the potential to improve the risk-adjusted returns over the economic cycle. Not only do hedge funds represent an increasingly attractive alternative to money market funds, whose popularity will gradually diminish as central banks cut rates, but they are also able to offer a degree of capital protection in the event of market volatility.